101 Concepts for the Level I Exam

**Gordon growth model (Constant growth dividend discount model): **assumes that dividends will grow indefinitely at a constant growth rate. The value of the stock is calculated as:

Calculate the value of a stock that paid a $10 dividend last year, if dividends are expected to grow forever at 6% and the required rate of return on equity is 8%.

__Solution:__

D_{1} = D_{0} x (1 + dividend growth rate) = $10 x 1.06 = $10.6

g is the sustainable growth rate i.e. rate at which earnings and dividends can continue to grow indefinitely. It is calculated as:

g = retention rate * ROE

**Multi-stage dividend discount model: **used for companies with high growth rate over an initial few number of periods followed by a constant growth rate of dividends forever.

Dividends of a company are expected to grow at 15% per year for three years, after which they are expected to grow at a constant rate of 5% per year. The last dividend paid was $2. Calculate the value of the stock of this company if the required rate of return is 10%.

__Solution:__

D_{1} = $2 x 1.15 = $2.3

D_{2 }= $2.3 x 1.15 = $2.645

D_{3} = $2.645 x 1.15 = $3.042

D_{3} will grow at a constant growth rate of 5%. Hence,

Finally,